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Defense Wins Championships
Prior to the start of this year's Stanley Cup Finals, the hockey world was buzzing with talk of Sid "the Kid" Crosby and the offensive firepower of the Pittsburgh Penguins. In the hype leading up to the Super Bowl, few fans believed that the high-scoring New England Patriots would lose to the New York Giants. Yet the Giants did beat the Pats, and the Detroit Red Wings seem well on their way to hoisting the Stanley Cup. A strong defense can render a potent offense powerless, as we have seen in both cases. Perhaps there is some truth to the old sports cliché, "defense wins championships".
You could say that the same is true for traders. It doesn't matter how much money you earn if you fail to protect your account, and good risk management is the key. I always tell my students that our job is not to make money; our job is to defend against loss. If you can do that, the money will follow. In the world of trading, just like in the world of sports, defense wins championships.
Thank You
Thanks to everyone who wrote to me about the Australian Dollar – U.S. Dollar (AUD/USD) currency pair. It seems that more than a few of you caught the breakout that occurred shortly after we discussed the ascending triangle two weeks ago in the article "Aussie Ascending". Several days after the article appeared, the AUD/USD pair shot 250 pips higher, rising above .9650 to a new twenty-four year high. To all of you who caught the move, congratulations. To everyone who missed it, there may still be another chance to get in. Breakout trades often pull back to their breakout point, giving traders a second opportunity. In fact, many traders prefer this pullback method of entry, believing it to be superior to the breakout method. Right now, Aussie is pulling back toward its breakout point of .9500. If it gets there, some traders might use that as an opportunity to buy some Australian Dollars and short the U.S. Dollar. Conservative traders might seek a pullback to the diagonal trend line, which currently resides near .9425 (see figure 1).
Figure 1: AUD/USD might be pulling back to its recent breakout point. Source: Saxo Bank
Why does the breakout point make an attractive entry point on a pullback? The answer lies in simple, basic psychology. Consider the chart above; the black line near .9500 represented resistance until it was broken last Friday. In the three months that preceded that breakout, the exchange rate made numerous attempts to break above .9500, with no luck, and during that time traders who sold short at .9500 were rewarded on numerous occasions. It's not a stretch to imagine that some traders may have sold Aussie short again last week, only to have the trade break through resistance and go against them.
Now when a trade goes against you, the right thing to do is just get out. For shorts, a stop should be located above the breakout point because support and resistance are not permanent. We have to accept the fact that our analysis might be flawed, or even if this is not the case, we just might be unlucky this time. There is no such thing as a surefire trade, since nobody can predict the future. So everyone who sold short at .9500 was taken out of the trade by their stops, right?
Wrong. Not everybody who trades uses sound risk management techniques, such as placing a stop in a location that, if hit, will prove that the initial reason for placing the trade is no longer valid. Since nobody likes to lose, and many traders are unwilling or unable to recognize when they should simply bail out of the trade, there are certainly traders out there still hanging on to their short positions. They are hoping, wishing, and praying for the AUD/USD exchange rate to drop back to .9500, so they can just break even. This is flawed thinking, yet it is common. While it may seem like hanging in there until things turn around is the right thing to do, it will eventually result in a big loss. I guess that's one of the reasons why trading is hard; what often seems right is wrong, and vice versa. That's why it's so important to have firm risk management rules and stick to them as if your trading career depends on it.
So if these traders sold short at .9500, the logical buy point to break even is also .9500, and we expect some buying pressure to come in if the exchange rate should reach this level. This is why resistance often becomes support, and support often becomes resistance. Will there be enough buying pressure to cause the price to remain above .9500? Nobody knows, but let's just say it couldn't hurt. Other traders who are not currently short may also consider buying at .9500, not to cover short trades but to enter long positions. Why? Because they know that support often becomes resistance, and resistance often becomes support. They are also aware of the tendency for round numbers like .9500 to act as a barrier. Like many aspects of technical analysis, there is a self-fulfilling nature to the relationship between support and resistance.
The important thing to remember here is this – don't waste your time kicking yourself if the entry never occurs, and don't chase after it and enter at the wrong location. Usually when traders waste their time worrying about what might have been, they miss other opportunities that are equally attractive or even superior to the one they missed! Don't fall into this trap; there are more opportunities out there than you could possibly trade. Part of being a professional is to realize this fact and simply move on to the next chart.
Speaking of the Next Chart…
In last week's article, I wrote to you about how the Australian Dollar – New Zealand Dollar (symbol AUD/NZD) currency pair was rapidly approaching prior resistance created back in 2006. Well, the pair hit the wall hard when it reached the resistance point, located near 1.2400, and failed to break through to new highs despite numerous attempts. AUD/NZD pulled back sharply to its 20 day exponential moving average on Thursday, and held the line there again on Friday. The pair has traded above its 20 day EMA for nearly two months (see figure 2).
Figure 2: AUD/NZD pulls back sharply to its 20 day exponential moving average. Source: Saxo Bank
Does this mean it's time to get long Aussie vs. the Kiwi? Perhaps, but there is one thing that troubles me about the chart, and that's the size of Thursday's candle, which indicates a sharp, swift pullback. This currency pair was testing two year highs and then pulled back to its 20-day EMA in the course of one day!
The point here is that velocity matters. There is a great deal of difference between a currency pair (or stock or commodity, for that matter) that gradually floats down to resistance, and one that races down to it like a falling knife. Friday's small candle provides some level of comfort, but I'd like to see more small candles form and see the price maintain its status above the moving average before I get too excited. As you can see by the Fibonacci retracements drawn onto the chart, the pullback still leaves us far short of the 38.2% retracement level, which lies near 1.1967. The run higher was so quick and massive that there was bound to be some profit taking at resistance, and I want to be sure that whoever is selling at 1.2400 has it out of their system. If I do enter, I'll proceed with caution.
Have a question about Forex trading? Send an email to eponsi@tradingacademy.com and we may use your question in an upcoming newsletter. Until next time, best of luck to you in trading.
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Ed Ponsi is a globally recognized name as a lecturer and teacher and is the former Chief Trading Instructor for Forex Capital Markets. An experienced professional trader and money manager, Ed has advised hedge funds, institutional traders, and individuals of all levels of skill and experience. Ed has appeared on CNBC, CNN International and TheStreet.com, and has recently written his first book for Wiley Finance, "Forex Patterns and Probabilities" (which you can purchase through